A good beginning

The timing appeared impeccable: the People's Congress passed the Securities Lbw in late December just as foreign investors were contemplating losing millions of dollars after the collapse of Gitic and bankruptcy threatened several other local government-backed red chip companies.

While not compensating for the lost money, the new law at least shows that the government is serious about building a proper legal framework for the securities industry. The confidence which drained from the industry has not been restored by a law which contains several contradictions and omissions. However Mr. Zhou Zhenqing, chairman of China Securities Regulatory Commission (CSRC), the ultimate watchdog of the fledgling securities market, has been quick to pledge a cleaning up of the industry and provide a stable investment environment for international investors.

Yet, if Zhou believes that the new law and his personal commitments are enough to win back the hearts of international investors, he is likely to be disappointed.

Despite its merits, the law, taking effect as of July 1, encapsulates the ill-defined concept of 'Chinese characteristics,' according to Anthony Neoh, visiting professor at Beijing University who has advised on its drafting. Previously, Professor Neoh headed the Hong Kong group in designing the legal and listing structure for overseas listing of Chinese enterprises between 1992 and 1993.

He went on to chair the Hong Kong Securities and Futures Commission between 1995 and 1998.

Indeed, Chinese characteristics are enshrined in the law's first article in the form of developing 'a socialist market economy.' This term is not defined in the law, but can be interpreted from what Zhou has pledged to undertake.

The majority shareholder
Zhou openly admits that some corporate management structures are "unsound" and advocates an arms-length relationship between local governments and listed companies. However, it is state policy to hold the shares in all listed companies via commercial arms. It is through these commercial arms that local governments exert their influence in varied ways, ranging from senior personnel appointments to inter-party commercial transactions.

Recently, international investors were outraged at a deal struck by Shanghai Industrial, a popular H-share company listed in Hong Kong, with its parent company Shanghai Industrial Investment Holdings, the commercial arm of the Shanghai municipal government. Although the minority shareholders managed to force the company's management to abandon the deal, the implication of the incident was clear: managers of listed companies are likely to succumb to pressure from their parent companies just as much as from government bureaucrats before a partial privatisation.

In the case of Guangdong Enterprise Holdings, the commercial arm of Guangdong provincial government which has listed several of its subsidiaries on the Hong Kong stock exchange, the outlook is even more worrying.

Reckless speculative securities trading led to the parent company racking up debts of nearly US$3bn at the beginning of the year, effectively making it insolvent and rendering worthless its financial guarantees for its various subsidiaries. One of them, H-share Guangnan Holdings with debts of nearly US$400m, announced that it would investigate the allegation that its parent had used funds the company had raised and deposited with it for speculative trading. Another subsidiary H-share Guangdong Investment will have to book a provision of about US$77m for non-performing assets and diminished value in investments, according to equity analysts. This will more than wipe out its estimated US$38m profit in 1998, leaving the firm in the red at the end of the financial year.

Even Professor Neoh admits that existing legislation in China is inadequate in dealing with these parent companies which potentially play a make-or-break role in listed companies.

The news that the provincial government is to bail out the cash-strapped Guangnan is no consolation to fund managers. "All of them [subsidiaries and their parents] are conspiring to con us of our money, it seems to me," says Mr. John Li, a fund manager of London-based Framlington Investment who is in charge of the company's Southeast Asia portfolio including China.

His strong sentiments pinpoint an important question that all international investors continue to ask when it comes to assessing China: are the management of a listed company able to work for enhancing shareholder value or just to enhance the value of the majority shareholder?

One of the important articles in the Securities Law designed to protect investors stipulates a segregation of clients' money and that of a securities firm for proprietary trading. As a result, almost all securities firms are in a desperate need for working capital, taking into account the sharp falls in A-share and B-share trading volumes and the dearth of primary issues over the past year.

However Zhou, the chairman of CSRC, has promised to help brokerages raise funds. "We're not particularly concerned about [the shortage of working capital], because the government tends to stop one route and open up another to compensate. There'll be a way out for us," says Mr. Fu Xinyi, senior manager of international business at Shanghai Shenyin & Wanguo, China's largest securities firm.

Threat to banking reform
One of the proposals under study, according to well-informed local analysts, is the possibility of letting the country's four major state commercial banks, jointly or separately, set up exclusive lending arms for brokerages.

Such policy lending, if realised, flies in the face of the spirit of commercialising the banking sector, which has long been used as a government cashier and risks derailing the whole process of banking reforms. Only 18 months ago, the CSRC banned the flow of bank funds into the volatile stock market.

The trouble for securities houses like Shenyin & Wanguo in the current bear market is that they cannot cut overheads at will. Unlike Western firms which cut jobs and merge with others in order to weather a recession, there have so far been no compulsory redundancies among Chinese firms in an attempt to cut costs.

There is limited scope for management autonomy in securities firms. For example, Shenyin & Wanguo moved offices five times in as many years, the latest as a result of the government-imposed merger of Shenyin with its former rival Wanguo. The overlapping elements of their business, instead of being streamlined, were simply merged. The costs of the move and the merger have contributed to the company's 1998 profits being nearly halved to about Yn400m from 1997.

International investors despair at the prospects of improving management quality so long as they continue to do as they are told. Senior executives of securities firms have to listen to orders from above, as the power of their appointment lies, not with their company board members or shareholders, but with the industry watchdog.

The powers of CSRC
CSRC's role as the highest authority in the industry is also enshrined in the new law. Early this year, the commission issued rules covering the appointment of board chairmen and general managers of securities houses as well as their deputies.

The rules specify that CSRC is “the only body authorised to approve the appointment of senior executives in the firms” and anyone appointed by their firms without the correct procedures will have their appointments declared 'invalid.' The rules also ban senior executives from assuming posts in the ruling Communist Party, some-thing of a puzzle since almost all board chairmen are concurrently Party chiefs and general managers deputy Party chiefs in their respective companies.

The power of CSRC that most epitomises 'Chinese characteristics' concerns the quota system. Despite the articles in the Securities Law that cover the issuance and listing of stocks and the current bearish market conditions which have in effect rendered the quota system redundant, CSRC has yet to pluck up courage to abolish the system.

Instead of approving the listing of companies on their financial merits, the quota system gives precedence to geographical locations of companies so that every part of the country has an equal access to the domestic and overseas capital markets. Last year's Yn30bn-worth of quotas were far from utilised because many provinces could not find suitable companies for listing. In the meantime, international investors were kept hungry for shares in growth industries such as telecommunications, retail and finance.
The CSRC has tried very hard in the past to stabilise the turbulent markets in China. Now it will try even harder. The Securities Law has laid down a legal frame-work and a sound basis for future development. But all investors should heed Professor Neoh's words: "The Chinese market is very unsophisticated; and so are its regulators."

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